Lakewood Capital – Review of the Quarter
The Lakewood Capital fund generated a net loss of 0.9% in the quarter. Although the fund’s long and short positions on average ended the quarter in roughly the same place they began, the start of 2016 was one of the most volatile and tricky periods we have seen in years as underscored by a 16% mid-quarter decline in the Russell 2000 Index. Defensive sectors like consumer staples, telecommunications and utilities performed very well in the quarter as record low interest rates pushed investors to bid up shares in companies they perceive generate stable cash flows while most other sectors languished. Long equity positions generated a -1% return on capital, hedged long equity positions generated a -5% return on capital, short equity positions generated a +1% return on capital and fixed income positions generated a +2% return on capital.
The Lakewood Capital fund’s largest winners in the quarter were long positions in HCA Holdings (64bps), Ingram Micro (60bps) and FedEx (59bps). I discussed HCA in our second quarter 2015 letter, and after a temporary spike in labor costs caused a sell-off in the stock in the third quarter of 2015, the company announced strong fourth quarter results, leading to a sharp rise in its shares. I have mentioned Ingram Micro on several occasions over the years (we initiated our position six years ago), and during the quarter, the company agreed to be acquired at a substantial premium to its trading price. It is gratifying to see a private market buyer recognize the company’s considerable value that we have highlighted numerous times over the years. I shared our thesis on FedEx in our third quarter 2015 letter, and the shares increased during the quarter as the company continued to deliver impressive earnings performance and appears poised for continued growth.
The Lakewood Capital fund’s largest losers in the quarter were long positions in Citigroup (88bps) and Citizens Financial Group (80bps). Both Citigroup (discussed in our fourth quarter 2014 letter) and Citizens Financial Group (third quarter 2014 letter) declined during the quarter as a result of general weakness in the financials sector. While investors have grown concerned about the impact of rising credit costs and low interest rates on financial stocks, we believe both Citigroup and Citizens have significant excess capital positions to weather any losses and each company has sizeable cost reduction opportunities to boost profitability. At valuations well below tangible book value and solid prospects for these businesses to generate attractive returns on equity, we believe the shares in both companies have tremendous upside in the coming years.
Lakewood Capital – Some New Ideas
We continue to find many interesting new ideas, particularly on the short side. Below, I briefly discuss our views on our long position in Clydesdale Bank and our short positions in Hormel Foods, Tyson Foods, Advanced Drainage Systems and Badger Daylighting. Clydesdale Bank (Long) We initiated a long position in Clydesdale Bank (which recently changed its corporate name to CYBG) during the quarter and believe it is a classically undervalued spin-off with the potential to double in value over the next two to three years. Prior to its partial IPO and spin-off in February, Clydesdale had been a small and neglected subsidiary of National Australia Bank (NAB), a large Australian bank headquartered more than 10,000 miles away from Clydesdale’s operations in the United Kingdom. Due to legacy issues at Clydesdale, regulatory pressures to simplify operations at NAB and the nuisance value of managing a U.K. operation that contributed just a few percent of total group earnings, we believe that NAB was a price insensitive seller, resulting in an IPO valuation of just 58% of tangible book value. At the current share price of £2.30 per share, Clydesdale still trades at just 75% of tangible book, an attractive valuation for a bank with strong (and likely excess) capital levels that should reach double-digit returns on equity over the next few years.
Clydesdale is a $3 billion market capitalization U.K. bank that operates primarily in northern England and Scotland under two local bank brands, Clydesdale and Yorkshire, and is mainly focused on residential mortgage, credit card and small business lending. Prior to its IPO, Clydesdale had been a relatively small subsidiary of NAB and was poorly managed for many years. Clydesdale had significant management turnover under NAB and was described by the new management team as a “revolving door of expat talent” that resulted in a “confusion of the strategy and a short-term approach.” As a result, Clydesdale currently has a relatively high cost / income ratio of 75% and a low return on tangible equity of 5%. However, we believe that a new management team has positioned Clydesdale to significantly improve operations in the coming years. Clydesdale’s management team is led by CEO David Duffy who joined the company in June 2015. He had previously been CEO of Allied Irish Bank (AIB) from December 2011 to May 2015 where he led an impressive turnaround effort that was centered on the delivery of significant cost savings through workforce reductions and branch closures. While at AIB, Duffy was able to reduce the company’s cost / income ratio from 96% in 2011 to 52% through a €350 million cost reduction effort. We believe that Duffy plans to replicate the AIB playbook at Clydesdale over the next few years and are optimistic about his ability to deliver on Clydesdale’s current target for a cost / income ratio below 60% and double-digit returns on tangible equity by 2020.
We believe our investment in Clydesdale has several sources of significant upside. First, we believe there is a sizeable cost reduction opportunity beyond management’s stated plan, which was developed by NAB prior to the spin-off. Given the magnitude of the cost improvements Mr. Duffy was able to achieve at AIB and our discussions with him around the long-term cost structure of Clydesdale, we believe the company’s current targets are conservative. For example, management has guided to an expense base for 2016 that includes elevated regulatory and IT investments that should decline over time as the projects conclude. Clydesdale also currently operates with a significantly higher employee headcount than its peers. By comparison, Lloyds Bank has 20x the asset base of Clydesdale but just 10x the employee count, while Virgin Money has 20% fewer assets but 60% fewer employees. Additionally, management has indicated a goal of reducing the branch network from 275 currently to around 200. We believe that the planned roll-off of regulatory and IT spending, headcount reductions and the potential closure of 25% of the branch network provide management with material incremental cost reduction opportunities. Furthermore, if the company were to move to advanced risk weightings for the calculation of its capital ratios, it would release excess capital equivalent to roughly 50% of its current market capitalization. Clydesdale currently uses a more conservative, standard approach to calculating risk-weighted assets while many U.K. banks use an advanced approach for their regulatory capital calculations. In order to receive regulatory approval to move to an advanced approach, Clydesdale needs to demonstrate its ability to accurately predict losses using its risk models. This process takes time and is not factored into our base case or management’s plan, but management is confident that they can move a large portion of the bank’s portfolio to the advanced methodology over time. By management’s estimation, this change could free up as much as £1 billion of excess capital (half of Clydesdale’s current market capitalization) that could be returned to shareholders or used to grow the business. Finally, we believe Clydesdale could be an attractive acquisition target. As an example, TSB Bank was spun out of Lloyds in June 2014 at 80% of tangible book and was subsequently acquired by Spanish bank Sabadell in 2015 for 1.0x tangible book. Compared to Clydesdale, TSB had a higher cost structure and lower capital levels. We believe that Clydesdale currently offers substantially greater upside to a potential acquirer than TSB did in 2015. By 2019, we believe Clydesdale can achieve a slightly higher than 50% cost / income ratio and earn a return on equity of around 10%. Assuming the stock trades at 12x forward earnings and 1.2x tangible book value, Clydesdale would be worth £4.50 per share including dividends in around two and a half years, which would amount to almost double the current share price and a 30% annualized return. If the bank can move to advanced risk-weightings, there could be over £1.00 per share of additional excess capital, which would result in 40% to 50% of incremental upside to the current share price.
Lakewood Capital – Hormel Foods (Short)
During the quarter, the Lakewood Capital fund initiated a short position in Hormel Foods, a company primarily focused on selling processed pork and turkey products. Over the years, we have uncovered many of our best short opportunities in mundane and competitive businesses that have experienced a significant increase in their valuations following an unsustainable increase in margins and earnings. Since early 2014, Hormel shares have increased nearly 75% and currently trade at a lofty 25x earnings as a sharp rise in operating margins resulted in attractive earnings growth at a time when investors have been bidding up the shares of “safe” consumer staple stocks. We believe Hormel has benefitted from an ideal environment for commodity pork processing that will soon normalize and force investors to return their focus to weak demand trends and the inherent volatility of the company’s commodity businesses. Many consumers know Hormel from its popular branded products that include Spam, Applegate Farms, Jennie-O, Skippy and Muscle Milk. While these well-known consumer staple brands create the impression of a stable, utility-like food business, the company actually derives two-thirds of its profits from its low margin commodity pork processing and turkey farming businesses. In addition to being volatile, these businesses both face secular pressures as per capita consumption of pork and turkey peaked in 1971 and 1996, respectively. Total consumption of pork and turkey has been declining for the last several years and Hormel has not reported organic volume growth since 2011, with annual declines averaging 1.3%. In the ten years leading up to 2013, Hormel’s operating margins fluctuated between 7% and 10%. Since 2013, a nearly perfect operating environment has pushed current operating margins over 13%, 500 basis points above the historical average. While bulls claim that much of Hormel’s margin expansion has been the result of an effort to sell further-processed pork products (e.g., seasoned and marinated), we believe that Hormel has simply benefited from a massive commodity tailwind that is now beginning to normalize. Hormel purchases live hogs, slaughters them and processes them into various pork products. Generally the retail price of pork products closely tracks the price of live hogs. However, this correlation can break down from time to time. In late 2013, an outbreak of a pig virus led to a significant reduction in the live hog supply and a rapid increase in the prices of both live hogs and processed pork. Farmers responded by expanding the supply of live hogs and the price of live hogs quickly declined. Retail pork prices have lagged on the way down and processors like Hormel have enjoyed outsized profitability over the past couple of years as a result. We believe that pork processor margins peaked in Hormel’s most recently reported quarter and have experienced meaningful declines over the past several months. Processing margins should be further pressured by recently announced capacity additions coming online next year from a number of Hormel’s competitors. These additions reflect the largest annual increase in processing capacity in more than a decade.
Analysts expect Hormel to generate approximately $1.80 of earnings per share in 2018, nearly double 2013 levels. While the Street projects continued margin expansion, we expect Hormel’s earnings to decline in 2017 and 2018 as margins normalize. Even if we assume the company retains some of its recent margin gains, we believe Hormel will generate $1.35 of earnings in 2018, 25% below consensus estimates. Even at 18x that estimate (15% above Hormel’s 10-year average from 2004 to 2013), the stock would be worth $24 per share, nearly 40% below current levels.
Lakewood Capital – Tyson Foods (Short)
Much like Hormel above, we think Tyson Foods is a food company benefiting from a cyclical tailwind that is nearing an end. Tyson is primarily focused on producing chicken, pork and beef products. In addition to a pork processing segment that faces the same issues as Hormel, we believe that Tyson is over-earning in its core chicken business. With the stock up 50% in the past six months, we believe there is significant downside as industry conditions normalize. Historically, Tyson’s chicken business has produced volatile results with low margins (operating margins ranged from -2% to 8% between 2000 and 2014). Following a challenging 2011, margins have steadily increased every year since and reached a record 12% in 2015, with a similar level expected in 2016. Over this period, chicken farmers have benefited from the high price of beef (a substitute product) and the decline in the price of corn (the primary feedstock cost). However, chicken farmers are starting to get greedy and are significantly increasing supply at the same time that cattle inventories are finally rising after nearly a decade of declines. Chicken supply increased by 4% last year, well above long-term per capita domestic demand growth of 1%, leading to a mid-teens decline in chicken prices. Based on the size of the current breeding flock, we expect supply to grow another 4% this year. Since Tyson’s margins actually expanded last year, some shareholders may have concluded that the company might be insulated from the pressures in the commodity market. However, the bulk of these price declines occurred in the back of half last year, and Tyson benefits from a lag in re-pricing certain contracts. Over time, we have observed that Tyson’s chicken profitability trails other commodity chicken farmers by one or two quarters, and peers have recently reported significant bottom line declines. Additionally, we expect increases in the supply of beef to pressure prices and remove the favorable pricing umbrella it has provided to chicken products. Back in 2013, a disease outbreak led to a 5% decline in the cattle herd intended for slaughter, resulting in a spike in beef prices. Unlike the chicken supply, which can be increased in less than one year, a new cow takes between three and four years to mature to an appropriate weight for slaughter. The supply response that began in early 2013 translated into 3% growth in 2015 ending cattle inventory, the fastest rate of growth in more than 35 years. We expect growth will accelerate throughout 2016 and 2017, which will negatively impact the price of beef and related protein products like chicken.
Given these headwinds, we believe Street estimates of high-single-digit earnings growth in 2017 are overly optimistic. We expect earnings will actually decline by approximately 10% to $3.60 per share in 2017. Tyson has historically traded at a substantial discount to Hormel and other consumer product companies due to its lower margin profile and much more volatile earnings stream. At 12.5x our estimate of 2017 earnings (a 20% premium to the historical average prior to the recent share price increase), Tyson’s stock would be worth $45 per share, 30% below current levels.
Lakewood Capital – Advanced Drainage Systems (Short)
We initiated a short position in Advanced Drainage Systems (ADS) in the third quarter of 2015 and added to our position earlier this year. ADS is the largest U.S. manufacturer of corrugated plastic drainage pipe for the underground construction and infrastructure markets. ADS went public in July 2014 at $16 per share, and despite being in the midst of a significant accounting restatement, the stock quickly doubled in price at its peak last year. Enthusiasm for the stock has primarily centered on the decrease in the price of oil, which reduces the company’s raw material costs and boosts profitability. We believe that the majority of any windfall profits the company earns will be quickly eroded by competition, forcing investors to focus on a much lower sustainable earnings level that has only recently been revealed due to the restatement process. Shortly after its IPO and before even filing its first 10-K as a public company, ADS was forced to restate its financials and delay future filings. In the absence of any reliable earnings releases throughout 2015, we believe investors, aided by a promotional management team, were enticed by the potential margin benefits from raw material price changes. ADS’s pipe is made primarily from high density polyethylene, which has dropped dramatically in price over the past year as it is tied to oil and natural gas prices. In contrast, much of the drainage market is served by concrete pipe, where raw material pricing has been increasing. While ADS’s profitability will temporarily benefit from these raw material shifts, ADS has plastic pipe competition that will significantly reduce this windfall over time. Furthermore, this raw material tailwind may soon become a drag on profitability as current spot prices for high density polyethylene are above last fiscal year’s average price. Last month, ADS finally re-filed financial information for the year ended March 2015. The restatement process took significantly longer than expected, the scope of errors was wider than initially indicated and the company continues to be delinquent on its latest quarterly filings. While management conveniently highlighted that the impact to adjusted EBITDA was insignificant, the company reclassified operating leases as capital leases, a maneuver that increases EBITDA but also increases depreciation and interest expense. The restatement led to reductions in adjusted net income for each year from 2012 through 2015 of 18%, 21%, 6% and 53%, respectively. For the most recent reported year ended March 2015, ADS reported adjusted earnings per share of $0.29, which is also the average level of earnings for the four previous years. ADS’s stock has actually increased since these restated numbers were revealed and the current stock price equates to a multiple of over 80x fiscal 2015 earnings.
Giving the company credit for capturing a portion of the raw materials benefit on an ongoing basis, we think a realistic estimate of earnings power is about $0.75 per share. At 15x this earnings power (a generous multiple given the accounting uncertainties), the stock would be worth $11 per share or 50% below the current price.
Lakewood Capital – Badger Daylighting (Short)
In the fourth quarter of last year, we initiated a short position in Badger Daylighting, the largest provider of hydrovac excavation services in North America. Badger manufactures and operates hydrovac trucks, which spray water to expose underground infrastructure primarily for the utility and petroleum industries. Badger’s stock has more than tripled in the past five years as the company’s fleet of trucks has expanded 20% annually with revenue slightly outpacing truck growth. This rapid growth has largely been driven by the shale boom, a strong utility capex cycle and increased adoption of hydro excavation technology, where Badger has held a first mover advantage. We believe many of these tailwinds are quickly reversing as low oil prices, stabilizing utility capex and increased competition pressure both pricing and utilization. Badger began offering hydro excavation services over twenty years ago, and as one of the pioneers of the industry, the company has historically been well positioned to capitalize on the growing use of hydrovac equipment. As the industry grew in size, several thirdparty manufactures began selling hydrovac trucks to smaller upstart players at prices similar to Badger’s own in-house cost of production, limiting the benefits of vertical integration. Additionally, as customers have become increasingly knowledgeable about hydrovac excavation, they have focused more on finding the cheapest price rather than prioritizing experience (some large customers are even buying their own trucks and insourcing hydro excavation services). With low barriers to entry, competition has accelerated with entrants ranging from smaller regional players to larger national environmental companies such as Clean Harbors (which the Lakewood Capital fund has been successfully short in the past). Badger has also contributed to the growing competition as a consequence of its extremely high turnover rate of mid-level managers. Many of these former employees have either started their own businesses or begun to work for competitors. Since the business is operated on a local level, Badger’s larger scale offers minimal benefits. The growing competitive environment can be observed through Badger’s declining revenue per truck, which fell 7% in 2014 and 20% in 2015 (before the full effect of lower oil prices has been realized). Furthermore, the macro tailwinds that have benefited Badger in recent years have begun to turn. With U.S. rig count currently estimated at just 23% of 2014 peak levels, total oil and gas spending is projected to fall by 25% to 30% in 2016, which will have a material impact on spending for hydro excavation services for new wells. Also, according to the Edison Electrical Institute, U.S. transmission capex spending (a large driver of hydro excavation revenue) is expected to remain roughly flat in the coming year after rising on average by 17% per year from 2009 through 2014. Since Badger’s business tends to be late cycle, these dynamics have only recently begun to impact its numbers (in fact, Badger management recently noted that the fourth quarter of 2015 was the first to be materially impacted by the U.S. oil and gas slowdown). Badger management projects it will double its U.S. fleet size in 2019 from 2014 levels and continues to target a rebound in revenue per truck to 2014 levels (despite the decline of 20% in 2015). With the stock trading at nearly 18x last year’s adjusted earnings, we believe investors still view Badger as a growth company and have failed to appreciate the growing risks to profitability. Given the increased competition and weak spending environment, we expect Badger’s returns on invested capital will begin to approach its cost of capital resulting in sustainable earnings power of roughly $1 per share or lower. At a valuation of 1.5x invested capital and 13x earnings, Badger’s stock would be worth around $13 per share or roughly 45% below current levels.
We look forward to the rest of 2016. We are excited about the return potential for both our long and short positions, but given fairly elevated overall stock valuations and growing economic risks and uncertainty, we have been careful to ensure the Lakewood Capital fund is well positioned to aggressively take advantage of new opportunities as they arise. As always, we are intently focused on delivering attractive returns while protecting your capital.
We remain grateful for your support, and we welcome any questions or comments.
Anthony T. Bozza